An Empirical Analysis of Changes in the Relative Timeliness of Issuer-Paid vs. Investor-Paid Ratings

We investigate the lead-lag relationships between issuer- and investor-paid credit rating agencies, in the aftermath of the regulatory reforms undertaken in the U.S. between 2002 and 2006 —including watch list inclusions and outlooks. First, we find that the lead effect of investor-paid over issuer-paid credit rating agencies has weakened: in recent years, causality has turned bi-directional. Second, when changes in outlooks are included, we find evidence of a less conservative behavior by issuer-paid agencies, when compared to their rating behavior. Third, stock prices manifest statistically significant abnormal reactions to downgrades of all agencies; however, abnormal negative returns are significantly higher for investor-paid downgrades. Our results support the hypothesis that when issuer-paid agencies have seen their market power threatened by tighter regulations, they have felt incentives to improve the quality and timeliness of their ratings. However, event studies show that markets still price stocks under the assumption that investor-paid rating actions carry superior information. JEL Classification Codes: G24, G28. Keywords: rating agencies, timeliness, issuer-paid agencies, investor-paid business model, NRSRO